Shareholder borrowing using corporate-owned assets as security - Back-to-back loan rules comfort
The Canada Revenue Agency (CRA) has provided comfort that the back-to-back loan rules will not apply in situations where a corporation’s asset is encumbered to provide collateral security for a loan to the corporation’s shareholder. The question specifically asked about a corporate-owned life insurance policy, mutual fund or term deposit with a different bank than the one lending money to the shareholder.
In response to Question 1 at the 2018 Conference for Advanced Life Underwriting (CALU) CRA Roundtable, the CRA said that neither subparagraph 15(2.16)(c)(i) nor (ii) of the Income Tax Act would apply. If either one of these sections of the Act did apply, the back-to-back loan rules would apply resulting in the loan being included in the shareholder’s income.
The test in (ii) requires that a “specified right” be granted to the bank. In an example where Corporation B encumbers its property to secure a loan for its shareholder Ms. X, the CRA confirmed that:
If, under the arrangement between the parties, the bank can only exercise its right to encumber in order to secure payment of Ms. X’s shareholder debt (for example, by placing a lien on the encumbered property to ensure that Corporation B cannot dispose of it without the bank’s consent), the right to encumber would not constitute a specified right. However, if under the arrangement between the parties, the bank can exercise its right to encumber in order to raise capital for itself, then…the right to encumber would constitute a specified right.
The legal documentation and resulting rights between the parties is important in determining if a specified right exists. You can learn more about back-to-back loans and specified rights in -Back-to-Back” Loan Rules and Shareholder borrowing using corporate-owned life insurance as collateral security.
In response to whether the test in (i) applies in this scenario, the CRA stated that it would not because in this situation, “the funder (i.e. the bank), and any person or partnership not dealing at arm’s length with the bank, does not have an amount outstanding as or on account of a debt or other obligation that is connected to the shareholder debt…” Since there was no specified right in these circumstances, neither of these tests was met.
So, neither test was seen to apply where the corporate-owned property that is given as collateral security is only available to the bank (or person related to the bank) to secure the repayment of the loan made to the shareholder, and not for other reasons (i.e. for its own use).
The CRA’s answer resolves the fuzziness previously commented on in my earlier article, The Canada Revenue Agency comments on back-to-back loan rules, which had posed this very question.
There are still many issues to consider when undertaking shareholder borrowing using corporate-owned life insurance as collateral security – e.g. shareholder benefit issues while the loan is outstanding and upon repayment at death, using the capital dividend account at death, the valuation of the shares at death – but the back-to-back loan rules do not seem to be one of them.